Activity cycle in a “downturn” stage

Government bonds: Neutral position on the US curve

The activity cycle now appears to have decidedly entered the “downturn” stage after some marked deceleration in the US, the euro zone and Canada (which has moved into the recession stage), as cracks appear in economic releases for several regions. The economic cycle appears to be running out of steam and the probabilities of a downturn are now well anchored. Europe also mirrors this situation, with all sub-indicators pointing to lower momentum and weaker activity. The UK has now seen a very sharp deceleration which has confirmed the slowdown observed in recent months and has clearly entered into the recession stage. Meanwhile, the inflation cycle appears to have reached a peak, too, with the US index off its highs, as the housing segment continued to decline significantly. In Europe, though the indicator remains strong, momentum appears to have stalled in recent months. All in all, the inflation picture is still sturdy across developed markets, with the UK remaining a stubborn exception, but momentum there has stalled, too. In the current context of increased downside risks to the economy, central banks across the globe have adopted a distinctly dovish stance. Chairman Powell, for example, has implied that there will be no further rate hikes in 2019. In line with this sentiment, the ECB, for its part, has clearly ruled out any rate hikes in 2019 and promised another round of TLTROs in September. In the emerging market universe, the fiscal easing in China is likely to support the overall growth in the universe and EM central banks stand ready to provide monetary support to their economies.

Overall, a combination of lower growth, weaker activity cycle, softer inflation and extremely supportive central banks is indeed a positive sign for Fixed Income markets and spread products in particular. However, after three months of falling rates and tightening spreads, valuations are looking less appealing.

Going forward, the Fed has shown considerable hesitation regarding the strength of the US economy and is likely to be more flexible regarding its hiking cycle. The market context has also led investors to adopt a long position towards the short end of US rates and the positioning seems somewhat neutral. In the face of this complacency vis-à-vis US rates, we remain neutral on the US curve but continue to remain alert so as to be tactically positioned for any sudden rebound in rates, be it via outright shorts or break-even strategies. Indeed, better data on inflation and employment are likely to yield sharp upticks in US nominal rates. With sharp declines in their macro-economic scenario, we have also adopted a positive stance towards Australian and Canadian rates.

In the euro zone, core bonds are already rather expensive. Furthermore, the framework has turned slightly negative, driven by investors’ positioning, which appears to be quite long. Supply/demand dynamics are supportive, driven by April redemptions, PSPP reinvestments and important primary investor demand (B/C of 4-5). The dovish outcome of the March ECB meeting, with the announcement of a new series of TLTROs, the revised forward guidance and downward revisions on growth and inflation have pushed back a rate hike to 2020. In this context, upward risk towards the German rates should be moderated and we are hence keeping a neutral duration stance.

Long position in Euro Linkers

While most global linker markets, supported by commodity prices and risky assets, delivered positive performances, markets saw lagging performances from Euro linkers, of which, however, drivers subsequently became more supportive. There should be some reversal of the recent downturn in inflation in Europe, supported by the relative Euro depreciation and seasonal effects. The improvement in Euro break-even inflation protection and more attractive valuations should also help. We therefore now have a relative preference for Euro linkers while keeping a positive stance on US linkers.

Positive view on Spain and Portugal

Euro markets did very well over the past 3 months, particularly on the 10-year portion of the curve. Non-core markets continue to be supported by monetary policy, carry/roll-down and investors’ positioning. Country-wise, we maintain a prudent stance on Italy, where event risk will be driven by success of supply, upcoming rating reviews, economic data and politics. We have a favourable view on Spanish and Portuguese debt, which present attractive valuations, better economic and fiscal dynamics and relatively low political risk. Flow-wise, they should also – certainly Portugal – benefit more in relative terms from the ECB’s reinvestment policy. Amongst core countries, we have taken profit on our long stance on Belgium (following their strong run) and on political risk potentially rising with federal elections in May (a difficult process of government formation could pressure spreads).

Credit: Positive on US HY credit

In the context of more dovish central banks (Fed and ECB) supporting risk assets, spreads continue to tighten across the board on credit markets. On Euro IG markets, the strong momentum has erased much of the widening from the final quarter of 2018. The announcement of a new series of TLTROs (2 years) is reducing bank supply but the change in forward guidance is altering bank net-interest margins. However, the low-yield environment is supporting the case of the asset class, thereby supporting the cautiously positive exposure to the EUR IG asset class. On the high-yield segment, idiosyncratic risks have been rising and banks are increasingly cautious in terms of lending, reinforcing our low conviction on the high-yield asset class vs. EUR IG. The US HY market appears to be well supported by a stable oil price. Supply isn’t an issue, as estimated redemptions for the next 24 months amount only to $98 billion. Moreover, the Fed delivered a more dovish statement with more flexibility on its policy, providing some support on risky assets in the current moderate economic slowdown. Carry continues to be interesting. In this context, we favour a more diversified allocation to credit markets and continue to prefer US HY, EM debt (LC) and Eur IG vs EUR HY and US IG.

We are still moderately constructive on EMD HC after the first quarter as the asset class continues to explicitly benefit from the now outright-dovish Fed stance, the decline in US-China trade tensions and the supportive commodity-price evolution. Asset-class technicals for EMD HC remain positive, as YTD inflows have been solid and issuance has lagged expectations. Asset-class valuations are not as attractive as at the start of the year but there are pockets of value in select EM credits on which we are concentrating exposure.

In EMD LC, we have tactically added select FX longs in ZAR, IDR and CZK, on signs that global growth is bottoming up, betting that domestic growth in these countries remains subdued, keeping imports in check, while, for ZAR and IRD, the rebound in commodity prices should support the export side going forward .We are keeping an OW in duration of 0.70yr, banking on inflation continuing its slow slide toward historically low levels in EM and potentially below.

Hard currency

Although the EMD HC (+1.4%) return was positive, this was due mainly to its Treasury (+2.3%) component, as 10Y US Treasury yields declined by 31bps (to 2.40%) while the wider EM spreads (+14bps to 351bps) resulted in a negative spread return (-0.8%). Sentiment towards the asset class deteriorated in March as the resolution on the US-China trade deal was postponed and disappointing European and US activity data revived fears of a synchronized global slowdown and led to an intense flight to safer core rates. In Turkey, concerns over the YTD FX reserve loss, the persistent build-up of FX retail deposits, government-led manipulation of inflation and funding rates ahead of the local elections led to a sharp increase in risk premia. HY (0.5%) underperformed IG (2.4%), with Mexico (3.8%) and Peru (3.7%) posting the highest, and Zambia (-8.5%) and Lebanon (-4.0%) the lowest, returns.With a yield of 6%, EMD HC valuations are less compelling than at the end of 2018 after a strong start to the year and as EM risk premia have already largely priced in the US-China trade-tension de-escalation. The EM HY-to-IG spread is still attractive, as is the EM single-B rating category versus its US HY counterpart. The medium-term case for EMD remains supported by a benign US Treasury outlook, with the Fed shifting to outright dovish and by the ongoing rebound in oil that has only partially recovered from the Q4 correction. Global growth and trade stabilisation could support the next leg of EM spread compression, but we are expecting more data to confirm the positive trends. On a 1-year horizon, we expect EMD HC to return around 6%, on an assumption of 10Y US Treasury yields at 2.5% and EM spreads at 350bps.The top contributors to our performance were the underweight in distressed credits like Lebanon or credits with deteriorating fundamentals like Oman, South Africa and Turkey. The overweight in HY like Argentina and Zambia and the underweight in Asian and Latam US Treasury-sensitive credits detracted most from performance. We are still constructive on commodity exporters like Angola, Azerbaijan, Ecuador, Kazakhstan, Nigeria, Petrobras (Brazil), and Pemex (Mexico), given our positive outlook on the oil-price recovery. We also maintain an exposure to specific idiosyncratic re-rating stories (high-yielders with positive reform momentum) like Argentina, Ukraine and Egypt, which now appear even more attractive relative to the lower repayment risks.We took some profits in Ecuador and Turkey, and added exposure to Egypt (constructive fundamentals) and Qatar (attractively priced new deal). We added to our absolute (+38bps to 6.67yrs) and relative (+17bps to -0.15yr) duration positions as the Fed re-affirmed its dovish stance in March.

Local currency

EMD LC retraced by 1.3% in March, mostly from FX (-1.9%). Following a more-dovish-than-expected FOMC, EMFX attempted a short-lived rally. Data remain stronger in the US than in EM. Volatility ahead of the Turkish local elections weighed on the asset class. Core rates rallied a staggering 25bps as inflation ground lower and major central banks reiterated their plea for patience. High-beta currencies have tested the bottom of their recent range, with the TRY underperforming (-5.6%) after local dollarization reached records and central-bank reserves fell, followed by BRL (-3.6%) and ZAR (-2.5%). Asia FX outperformed, with IDR (-1.2%) and PHP (-1.5%) shielded by the stability of the Chinese RMB (-.4%). In rates, Latam outperformed massively, with Mexico, Colombia, Peru and Chile rallying 20bps in line with UST, followed by Asia, where Indonesian and Malaysian rates rallied by 18bps.We believe that, with a yield of 6.3%, EMD LC compares well to FI alternatives, especially as we are now expecting a respite from US-China trade tensions and US growth exceptionalism, and a more dovish Fed policy stance. On a 1-year horizon, we expect EMD LC to return around 6%, assuming a conservative -1.6% EMFX and +0.8% duration returns. EMFX are unlikely to outperform in a global growth slowdown, although external rebalancing is occurring in most EM, and EM central banks have managed to deliver hiking cycles that maintain attractive FI risk premia versus DM. We expect quantitative tightening to be paused in the US and delayed in Europe; this should also support EMD LC.Our performance was helped by long-duration exposure to Mexico, Peru and Indonesia, as well as underweights in FX, PHP and MXN.

Currencies: Neutral position on USD

Developed Markets

The overall framework, based on investor positioning, trade and capital flows and PPP, is negative for the USD. The twin deficits exhibited by the US should keep the greenback under pressure vs. major currencies. Furthermore, the trade wars between the US and China, compounded by declining activity and inflation cycles, are likely to have a negative effect on the greenback,. However, with unemployment at historic lows, a small improvement in inflation could lead to the risk of the Fed implementing a hike, in support of the USD. The potential trade deal could also be a source of positive momentum on the USD. In this context, we prefer to have a neutral position on the currency.

Though rate differentials remain penalizing, the JPY – based on our long-term framework – appears attractive, though less so than in the past. In the current environment of geopolitical uncertainty and the heavy dose of event-risk present, the JPY remains an attractive safe haven and a diversifying asset. Nevertheless, flows are preventing a large appreciation of the currency as the Japanese are buying US bonds.

Emerging markets

We don't see grounds at this point for a prolonged rebound in EMFX, even though duration should be supported by lower inflation and mild growth throughout. The USD position is concentrated against short Asia low-beta FX. We moved duration in low-yielders from UW to neutral and reinforced the overweight in select high-yielders. Relative duration is 0.71 yr (+0.38 yr).